Accounting and auditing standards: Meaning, Criticisms & Real-World Uses

What Are Accounting and Auditing Standards?

Accounting and auditing standards are established guidelines and rules that govern how financial information is recorded, presented, and verified. These standards are fundamental to the broader field of financial reporting and governance, ensuring consistency, transparency, and reliability in a company's financial statements. Accounting standards dictate the principles for recognizing, measuring, and disclosing financial transactions, while auditing standards provide the framework for independent auditors to assess the fairness and accuracy of those financial statements. Together, these accounting and auditing standards are crucial for maintaining investor confidence and facilitating efficient financial markets.

History and Origin

The evolution of accounting and auditing standards is closely tied to major economic events and the need for greater financial transparency. In the United States, the groundwork for modern accounting standards, known as Generally Accepted Accounting Principles (GAAP), was laid after the stock market crash of 1929 and the ensuing Great Depression. This financial turmoil highlighted significant deficiencies in corporate financial reporting, leading to the establishment of regulatory bodies. The Securities Act of 1933 and the Securities Exchange Act of 1934 were pivotal, giving rise to the Securities and Exchange Commission (SEC) to oversee securities markets and ensure standardized financial reporting³¹,³⁰.

The SEC delegated the responsibility for setting accounting standards to the private sector, eventually leading to the formation of the Financial Accounting Standards Board (FASB) in 1973,. On the global stage, the International Accounting Standards Committee (IASC) was established in 1973, later reorganized in 2001 into the International Accounting Standards Board (IASB), which develops International Financial Reporting Standards (IFRS)²⁹,.

A significant development in auditing standards occurred in response to major corporate accounting scandals of the early 2000s, such as Enron and WorldCom. These incidents exposed severe shortcomings in corporate oversight and audit practices. In response, the U.S. Congress passed the Sarbanes-Oxley Act of 2002 (SOX)²⁸. SOX created the Public Company Accounting Oversight Board (PCAOB) as a nonprofit corporation to oversee the audits of public companies for the first time in U.S. history, moving from self-regulation to independent oversight of the auditing profession²⁷,,. The PCAOB's rules and standards must be approved by the SEC²⁶,²⁵.

Key Takeaways

Foundation of Trust: Accounting and auditing standards provide a common language for financial reporting, fostering trust among investors, creditors, and other stakeholders by ensuring consistency, comparability, and reliability of financial information.
Regulatory Oversight: Bodies like the FASB and IASB develop accounting standards, while the PCAOB sets auditing standards for public companies under SEC oversight, driven by the need to prevent fraud and ensure market integrity.
Global Harmonization: There is an ongoing effort to converge or harmonize accounting standards globally, particularly between GAAP and IFRS, to facilitate cross-border investment and business activities.
Dynamic Nature: Accounting and auditing standards are not static; they evolve continually in response to new business practices, financial instruments, technological advancements, and emerging risks.

Interpreting Accounting and Auditing Standards

Interpreting and applying accounting and auditing standards requires a deep understanding of both the specific rules and the underlying principles. For accounting standards, this involves correctly classifying transactions, applying appropriate measurement bases (e.g., historical cost or fair value), and ensuring all required disclosures are made in the financial statements. The goal is to provide a "true and fair" view of a company's financial position and performance. Financial professionals, including accountants and financial analysts, use these standards to prepare and evaluate a company's financial health, making comparisons across different periods and companies possible.

For auditing standards, interpretation centers on the auditor's professional responsibilities and the procedures required to form an opinion on the financial statements. This includes assessing the effectiveness of a company's internal controls, gathering sufficient appropriate audit evidence, and maintaining auditor independence. The resulting audit report provides assurance to users that the financial statements are free from material misstatement.

Hypothetical Example

Consider a hypothetical software company, "InnovateTech Inc.," which develops and sells cloud-based solutions. When InnovateTech recognizes revenue from a multi-year subscription contract, it must adhere to specific accounting standards. Under GAAP, revenue recognition principles guide when and how the company records income from these contracts. For instance, if the contract includes distinct performance obligations (e.g., software access, customer support, and future upgrades), InnovateTech cannot recognize the entire contract value upfront. Instead, it must allocate the transaction price to each performance obligation and recognize revenue as each obligation is satisfied over the contract period, often monthly for software access.

During its annual audit, InnovateTech's external auditors will examine these revenue recognition practices. They will verify that the company's accounting methods comply with the applicable accounting standards, scrutinizing the contracts, supporting documentation, and the system used to track subscription revenue. The auditors' work, governed by auditing standards, ensures that the reported revenue in InnovateTech's income statement accurately reflects the services delivered, providing reliable information to investors.

Practical Applications

Accounting and auditing standards have widespread practical applications across the financial ecosystem:

Corporate Reporting: Publicly traded companies are legally required to prepare their financial statements in accordance with the accounting standards mandated by their respective jurisdictions (e.g., GAAP in the U.S., IFRS in many other countries). This ensures that investors receive consistent and comparable information. The SEC oversees this compliance for U.S. public companies²⁴.
Investment Analysis: Investors and financial analysts rely on standardized financial reports to assess a company's performance, financial health, and future prospects. The consistency provided by accounting standards allows for "apples-to-apples" comparisons between companies, aiding in investment decisions.
Lending and Credit Decisions: Lenders and creditors use financial statements prepared under accounting standards to evaluate a company's creditworthiness before extending loans or credit.
Regulatory Compliance: Regulatory bodies, such as the SEC and the PCAOB, utilize these standards to enforce laws, protect investors, and maintain fair markets. The PCAOB, for example, inspects audit firms to ensure they adhere to auditing standards, which helps safeguard the integrity of public company audits²³,²².
Internal Controls and Corporate Governance: Adherence to accounting standards necessitates robust internal controls over financial reporting. Auditing standards guide the evaluation of these controls, contributing to sound corporate governance practices within organizations.
Mergers and Acquisitions: During due diligence for mergers and acquisitions, accounting and auditing standards provide a common framework for valuing companies and assessing their financial positions.

Limitations and Criticisms

Despite their critical role, accounting and auditing standards face various limitations and criticisms. One significant concern is the inherent complexity of the standards themselves, which can make them challenging to apply and interpret, even for experienced professionals²¹. As transactions become more intricate and global, standard setters continuously add more detailed requirements, potentially leading to voluminous financial reports that can obscure rather than clarify information for investors²⁰,¹⁹. Some academic research suggests that this complexity can increase narrative obfuscation in financial reports.

Another critique revolves around the judgment required in applying principles-based standards like IFRS, which can lead to variations in practice and potentially reduce comparability across firms, even within the same industry¹⁸. Similarly, rules-based standards, such as U.S. GAAP, are sometimes criticized for being too prescriptive, potentially hindering the ability of financial statements to reflect economic reality when transactions do not fit neatly into predefined categories¹⁷.

There are also ongoing debates regarding the cost of compliance, particularly for smaller public companies. Adhering to comprehensive accounting and auditing standards can involve significant time and financial resources for companies and their auditors¹⁶,¹⁵. While the Sarbanes-Oxley Act improved reporting, its implementation also brought substantial compliance costs. Critics also point to instances where accounting standards may not adequately address emerging business models or intangible assets, leading to information gaps for investors¹⁴. Enforcement of standards is also a key challenge, with studies indicating a link between the level of enforcement and the complexity of standards¹³.

Accounting and Auditing Standards vs. Financial Regulation

While closely related and often discussed together, accounting and auditing standards are distinct from financial regulation.

Accounting and auditing standards are the technical guidelines for preparing and verifying financial information. Accounting standards (like GAAP or IFRS) dictate how financial transactions are recorded, measured, and presented in financial statements ¹²,¹¹. Auditing standards (like those from the PCAOB or IAASB) outline the procedures and professional responsibilities for examining those financial statements to ensure they comply with accounting standards and are free from material misstatement¹⁰,. They focus on the specific methodologies and principles for reliable financial representation and independent verification⁹,⁸.

Financial regulation, on the other hand, is a much broader concept within financial management. It refers to the comprehensive system of laws, rules, and oversight bodies established by governments and regulatory agencies to govern the entire financial industry, including banks, investment firms, and insurance companies⁷,⁶,. Financial regulation aims to ensure the stability and integrity of the financial system, protect consumers and investors, and prevent illicit activities like fraud⁵,,⁴. While financial regulation often requires adherence to specific accounting and auditing standards, it also encompasses other areas such as capital requirements for banks, consumer protection laws, market conduct rules, and anti-money laundering regulations. The SEC, for example, is a primary financial regulator in the U.S., and while it oversees accounting and auditing standards, its mandate is far wider, covering the entire securities industry³,².

FAQs

What is the primary purpose of accounting standards?

The primary purpose of accounting standards is to ensure that financial statements are prepared in a consistent, comparable, and transparent manner. This helps investors, creditors, and other stakeholders make informed decisions by providing reliable financial information about a company's performance and position.

What is the role of the PCAOB?

The Public Company Accounting Oversight Board (PCAOB) is a U.S. government-created non-profit corporation that oversees the audits of public companies to protect investors. It registers public accounting firms, establishes auditing and ethics standards, conducts inspections of registered firms, and investigates and disciplines firms for violations of professional standards¹.

Are accounting standards the same globally?

No, accounting standards are not the same globally. The two most prominent sets are U.S. Generally Accepted Accounting Principles (GAAP), used in the United States, and International Financial Reporting Standards (IFRS), used in over 100 countries worldwide. While efforts toward convergence have been ongoing, significant differences still exist between the two frameworks.

Why are auditing standards important?

Auditing standards are important because they provide a framework for auditors to conduct high-quality, independent examinations of financial statements. They ensure that audits are performed with due professional care, that auditors maintain independence, and that the resulting audit report provides a credible opinion on the fairness and accuracy of the financial information, thereby enhancing public trust.

How do accounting standards impact investors?

Accounting standards directly impact investors by providing a standardized and consistent basis for financial information. This allows investors to analyze and compare companies effectively, understand their financial health, and assess risks and opportunities before making investment decisions. Without these standards, it would be extremely difficult for investors to evaluate different companies fairly.